Description

What’s the opposite of AI?  Quite possibly this.  “Value” has gone through hell year to date and here’s a way to go the other direction.  Auto parts. Magna is a global auto parts company and not the sexy kind - they sell seats, body & chassis, mirrors, you name it. Importantly, the business is engine agnostic with the vast majority of sales (>90%) at least agnostic (seats, body panels, full car outsourcing) or positively impacted by industry “megatrends.”  This is not a gas tank manufacturer.

In fact, the EV angle may be underappreciated. Investors continue to give Magna little credit for their megatrend investments. The company has spent copious amounts of capital over the past few years to become a leader in areas such as battery enclosures, and these development costs are reaching an inflection point in profitability.  Megatrend investments should become profitable in 2025. They are seeing substantial growth in their products & systems to support EVs, Active Safety and Battery Enclosures which were a mere 2% of revenue in 2022 and will be 15% by 2027. 90% of their megatrend business for 2025 is already booked with most of the development spend behind them.

Their Complete Vehicle Assembly (they were long rumored to be the logical partner for Apple) capability gives them the unique ability to think like an automaker as a parts supplier and they expect their sales with OEMs to shift from components to integrators and systems [cameras, radar units, thermal imaging, electronic control units, fusion systems, etc]. Given increase in systems complexity in the future, they expect OEMs to outsource more. They believe they are building a competitive moat in battery enclosures and sales for this product category continue to surprise them to the upside. Investors continue to give Magna little credit for their megatrend investments. As these investments scale, turn profitable, and contribute more meaningfully to overall results this narrative will change.

Magna Has a Unique Culture – I consider this to be one of the two or three best auto parts suppliers in the world.  Though I also consider that to be the Buffett question posed decades ago that this is a horse that can count to three.  That doesn’t make the animal a mathematician.  Magna is one of the few companies that still compensates their employees with a profit-sharing model that emphasizes an ownership mentality at the division & group level. Their structure drives responsibility and responsiveness- if you are paid like a manager, you will react very quickly to changing circumstances. Their culture is not top down where they dictate what to do, but where all employees are decision makers all the way down to the customer.

Valuation is very compelling here – low multiple on low margins with a strong balance sheet. Not only is Magna trading at a historic low on valuation, but earnings are depressed. Magna was cheap in March.  And then dropped another 25%. Yes, they were selling to Fisker which is going broke, but it is a tiny part of their sales ($400 mm out of $40 bn+).  What I like most about Magna at 8x earnings are that those are trough margins making up the denominator of that low P/E.  Compare that to their customers the auto OEMs who are also low P/E but on very high margins because they have not had to discount for several years now with tight supply. 

That didn’t help Magna so much.  GM got the benefit of Magna eating those labor and raw material costs based on agreed to supplier contracts. The parts companies who have scale are clawing those customer recoveries back. Management has outlined 150+ bps of margin expansion over the next couple years.

They are currently guiding to 5.4-6% for this year. They are talking about 6.7-7.8%% by 2025. 

7% is by no means some crazy number, they averaged about that from 2014 to 2019.  100 bp of margin on $40 billion of revenues is $1 a share of EPS.  Estimates for this year are $5.50 on 5.4% EBIT margins. Margins of 6.5% would have been considered quite normal before covid.  So, you can do the math here – upside would be based on EPS of around $7 but you don’t need to dream here, 10x what they are earning now would get us to a total return of over 25% including the dividend.  11 x $7 of earnings in a more friendly environment would be a 70%+ gain.

As capital investments decline, FCF should inflect – According to management, their peak capex spend (as a % of sales) is behind them. As capex declines, they expect to see free cash flow increase each of the next three years to $2 billion in 2026.  That is not at all pie in the sky, it would simply mean earnings grow a little bit and free cash flow equals earnings. At today’s $12.7 bn market cap that is a 15.8% FCF yield a couple years out with minimal debt.

Magna has a strong balance sheet and capital discipline. This is a non-promotional management team that has taken a conservative view on everything from industry EV projections to how they calculate their leverage ratio (they include leases and don’t back out cash). The company has a target gross debt/EBITDA ratio of 1-1.5x, is currently around 2x as they define it, and expects to be within their range by next year.  

While I don’t know what light vehicle production estimates will do over the coming year, when things get dicey, companies like Magna can take advantage. They have the ability to take out struggling suppliers at a good price due to their scale and balance sheet.  In 2007-2008 there were a lot of opportunities to buy up suppliers and vertically integrate them. They brought in $1 bn worth of new business in ’09! They also have a history of market share gains as OEMs would rather partner with Magna given their financial resources, human capital, breadth of product offerings, and their global footprint.

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing.  The author will not undertake to supplement, update or revise such information at a later date.  The author may hold a position in the securities discussed.

Catalyst

Capex peak